The Psychology behind my Methodology

I stated in one my previous posts some of my rules in my trading methodology. They go as follows:

First: The trend is your friend. Find where is price going in the long term and never trade against it.

Second: Trade within your means: Never over trade or risk more than your account can handle.

Third: Never get into a trade you don't understand.

Now what I wanted to do here is explain the psychological reasoning behind each of the rules. The reason for each of these rules is to eliminate the human emotions or cognitive bias in our own trading but to also predict and profit from other person's emotions and cognitive biases. 

The main biases we want to avoid are:

Confirmation Bias & Semmelweis Reflex

Focusing 

Irrational Escalation

Post Purchase Rationalization

Wishful Thinking

The Trend is your Friend

Trading the trend doesn't have a significant effect on individual psychology. However, it is very useful in order to profit off of the band wagon effect. "Hey, that gold just keeps going up we should get in." Common example where being in a position ahead of the band wagon is an easy way to make money in the markets. 

Trade Within Your Means

This rule deals with wishful thinking. Many times traders, new and old, enter a position with insane amounts of leverage. In other words this rule deals with money management. If you can't handle the loss financially or emotionally don't put it on. You might as well burn the cash.

Never Get into a Trade You Don't Understand

This rules deals with all the other biases. Let me explain with an example. Some analyst writes an article on Apple (AAPL)and you like what he has to say. So you go and buy some Apple shares not understanding why. First thing that you do is reassure yourself that you've made the right decision, you are going through "Post Purchase Rationalization". So now you want some hard evidence supporting your position "Confirmation Bias" and your reject all the negative information "Semmelweis Reflex". So you now only focus on the good news "Focusing" until a terrible report is released that Apple is failing but you ignore it even though it is clearly is against your position "Irrational Escalation". Morale of the story don't enter if you don't have a plan or any background knowledge on the position. You may miss an opportunity maybe you may see a sell off as a buying opportunity if you did your homework. 

Thanks for reading and stay tuned for more trading advice, info and explanations and don't forget to visit my other website.